Landlords want to be assured of the economic strength of their tenants; however, determining what is the right amount of security can be difficult. In a perfect world, the landlord takes a full guaranty from a creditworthy person, especially if there is any question as to the tenant’s ability to pay the rent and meet its other obligations under the lease. However, the creditworthy principals behind the tenant will likely resist a full guaranty. After all, that is part of the reason some company principals choose to organize as corporations and limited liability companies.
In these situations, landlords may still be able to satisfy their need for security with a limited guaranty. The following three limited guaranties are possible options. Though not an exhaustive list, they should be a good starting point for negotiations with tenants and any potential guarantors, providing landlords with acceptable security for tenant obligations under the lease.
MAXIMUM DOLLAR CAP
The parties may agree to a maximum dollar cap on guarantor’s liability. The liability can be capped at any amount, and something is better than nothing. The cap of liability should be related to the value of the lease and the landlord’s potential loss. The larger the risk of loss from a tenant default, the higher the dollar cap should be.
Obviously, the perceived credit strength of the tenant is a factor, as well as whether it has been in business for several years or is a new company. Negotiating a maximum dollar cap amount for a limited guaranty would allow the lease guarantor to limit its potential liability to an acceptable amount, and it would also allow the landlord to mitigate its risk and reduce potential losses.
Alternatively, a formula can be used to create a cap that will cover a landlord’s foreseeable losses. This approach may allow more flexibility than a simple fixed cap. The following categories are commonly used to create a formula to cover certain out-of-pocket expenses incurred by the landlord at the start of any lease:
- the amount of the unamortized tenant improvement allowance and
- lease brokerage fees.
To the sum of those amounts might be added an allowance for preparing the leased space for a new tenant and an allowance for attorney’s fees expended to recover the premises. Some part of the rent, both past due and pending, might also be added. The following is an example of a formula-based guaranty:
Guarantor’s maximum liability =
delinquent rent + six months’ rent + unamortized tenant improvement
allowance + any allowances for recovering and preparing the leased space
Another variation on this approach is to provide that the number of months of rent that is covered reduces over time. If a tenant defaults in year one of a 10-year lease, the guarantor will owe one year’s rent plus the other guarantied amounts. If no default occurs until year five, then six months of rent might be guaranteed.
Of course, a formula-based guaranty will focus on the business considerations of the parties and will differ from lease to lease. A formula approach can be useful since it is more flexible than a maximum dollar cap approach. When using a formula-based guaranty it is important to define all key terms such as rent, attorney’s fees, maintenance costs, and others used in the formula. If the components of the formula are not specifically defined, then enforcement of the guaranty will be impaired.
A third option is a rolling guaranty. If the tenant performs and fulfills its monetary obligations under the lease for a certain period of time, then the landlord’s risk of loss declines, and the guarantor’s liability may be reduced. Thus, if a tenant does not default for the first 36 consecutive months of a seven-year lease, then the guaranty could expire at that point in time. Or the cap of the guaranty may decrease in stages over time. Finally, instead of the simple lapse of time, the cap on liability under a guaranty might decline upon reaching certain financial benchmarks, such as an increase in net worth, gross sales, or revenues. As long as the parties agree on the benchmark, any financial target can work.
These three examples of limited guaranties are just some of the ways to address a landlord’s need for security while attending to the desire of a lease guarantor to limit liability to a reasonable level. The keys to a successful lease negotiation when a separate lease guaranty is necessary or desired are for all parties to remain flexible and to understand the legitimate business needs of the other party. By doing so, the parties should be able to arrive at a mutually acceptable limited lease guaranty that facilitates the successful negotiation of the lease itself — and helps secure the landlord.